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Thursday, August 25, 2011

Loan Shark Descends on Bank of America

Berkshire Hathaway's Warren Buffett

The big news on Wall Street this morning is that gazillionaire Warren Buffett is investing $5 billion dollars in Bank of America. Like lemmings, pre-market traders are bidding up BAC's share price on the presumption that Buffett's blessing means the bottom is in. I remain on the other side of that trade and in fact view the momentary hype as one last opportunity for MainePERS to exit the stock before it crashes for good.

How quickly they forget. Just six months ago came the disclosure, through a filing with the SEC, that Buffett had sold all of his common stock in BofA by the end of 2010. It was a good thing for him that he did, as he was able to side-step a 48% slide in the stock price since January 1. Now Buffett is back for discounted merchandise. But why? The company is even more troubled now than it was on New Year's Eve, having just recorded a 20 billion-dollar hit to its balance sheet.

It turns out that it is not common stock that Buffett is buying, but preferred instead, which gives him seniority over common stockholders in the company's capital structure. Buffett will be getting a guaranteed 6% annual dividend (x $5 billion = $300 million from pre-tax profits) before common shareholders get their measly penny-a-share quarterly dividend, which is not guaranteed. As a sweetener, Buffett also gets warrants to buy up to 700 million shares of common stock at $7.14 a share at any time during the next ten years. Fully exercised, those options would give him 6.5 percent of the company.

This is a bad deal for Bank of America, which assumes a burdensome cost of capital in a zero-interest-rate environment. Management's credibility is now seriously undermined in the wake of assurances during a July 19 conference call with investment analysts that the company needed no additional capital. The usurious Buffett deal means that BofA not only needs capital, but cannot get it from public debt and equity markets. Concludes ZeroHedge: "The bank's only recourse was a private raise with a crony capitalist who is once again doubling down on the global ponzi."

Worst part is, the $5 billion is not nearly enough. The company's unmet liabilities are estimated in the tens of billions and may approach $200 billion. Buffett's intervention is like seeing a distressed swimmer being swept out to sea by a riptide and throwing him a...rubber duckie. And if Wily Warren loses his rubber duckie? No problem. Barack Obama, who worships the Oracle of Omaha, will buy him another one. Which, if that happens, will make me really mad.

It has happened before. In 2008 Buffett bought preferred stakes in both Goldman Sachs and General Electric, after which the stocks crashed 67% and 42% respectively. It took the TARP bailout to rescue Buffett's investment then. "If history repeats," notes EuroPacific Capital's Peter Schiff wryly, "it's more likely the banking stocks are about to get hammered."

The story is going around that Buffett concocted the BofA scheme while sitting in the bathtub Wednesday morning. Would it not be fitting if he ended up taking a bath on this latest flyer?

[update 08-30-11:]

David Weidner at Marketwatch explains here how the Buffett deal gouges holders of BAC common.

And John Hussman has this to say:

Warren Buffett's $5 billion investment in Bank of America preferred stock last week was essentially a defense of the old guard. Buffet observed, "It's a vote of confidence, not only in Bank of America, but also in the country." Yes - to be specific, it's a vote of confidence that the country will bail out Bank of America in any future crisis. We should all hope that Buffett's investment is successful - provided there is no future crisis - and we should equally hope that Buffett loses the entire investment otherwise.